Thursday, March 6, 2008

Waiting for the Leaders to Fall Before I Buy in any Scale

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For much of the past year we've had a very narrow market - meaning even on upswings it has been very few sectors who are benefiting, and the rest of the market is either flat or going down. This ebbs and flows, and sometimes the leadership changes - for example last fall it was technology, solar, agriculture, and infrastructure leading the way while the rest of the market did not do much. This is how I had a huge amount of outperformance in the fall as I was in these groups before they ramped - so good times were enjoyed. For a few weeks in late January we actually had (cough) leadership (if huge moves off dead cat bounces are leadership) in retail, financial, and home builders (I seriously underperformed those weeks).

Now the commodity complex is obviously running the show - our leadership is fertilizer, crops, coal, natural gas, mining, and gold/silver. I'm happy to say despite some blow ups in the bottom of the portfolio, having a focus on these groups (ex-natural gas which I totally missed), is keeping us doing quite well.

But this also leads to the problem... while these are my favorite groups; they are also the most prone to getting hit hard in a downturn (since other groups have already been hit very hard). This is what happened in mid January - many of my stakes in such names were getting hit for 8-9% a day, every 3rd day. Does it mean it has to happen again? No. But I am assuming it will. And in fact I cannot get very confident about being more long until I see these groups get hit. The popular term is "the generals must be shot".... i.e. the generals are the leadership. So despite having the best fundamentals, and no legitimate reason for being sold off, they will - if this correction scenario I envision plays out - get sold off. And potentially very severely. It happened in August 07, it happened in November 07, and it happened in January 08. It is just a matter of degree... we won't know how severe it will be, so this is why I layer in (and out) of positions. In November 07 I was "right on time" since my layering caught the bottom as that sell off, while 10% off on the indexes, did not hit the leadership groups to the same degree they were hit in August 07 and January 08. In those 2 time frames I was buying into the sell offs, but the stocks continued into free fall for another 8-12 days, and I was simply out of cash and fully invested so I could not catch the ultimate bottom. But no one really does on a consistent basis.

But it is hard for me to be constructive until we see the generals shot - despite my large weightings in groups that have been winning, we need to see them take losses (which will hurt the fund short term), before we can put in a bottom. So as I said a few days ago in the fertilizer group [Thoughts on Fertilizer], I am going to try to remain patient and wait for those moves down in those groups - until then I am just compiling my shopping list and waiting. I do believe the next group of leaders will for the most part be the same groups we have leading now for the foreseeable future (although technology is so beaten down I could see some of the old teflon stocks joining the next bull rush). Other groups might bounce harder or higher at first (like they did last time when we saw home builders, financials, and retailers out perform for a few weeks) but I expect them to fall back down YET again as we move through the late winter/early spring and the "2nd half recovery" folks are shown to be wrong (again) - most of these were the same people touting "1st half boom" or "no recession at all" last summer when problems started surfacing. Again, they will eventually be correct - but I am going on a thesis of a longer and deeper REGIONAL recession (not hitting all parts of America - i.e. areas focused on agriculture and energy or natural resources like coal still doing very well). So I'm going to continue to focus on companies with customers outside the US - those with cash, and rich in resources, and not massive debtor nations such as ourselves.

Frankly, I am not a credit or bond guy - I'm a "generalist" (try to cover as many areas as possible without being the ultimate 'expert' in any, but having a deep knowledge)... but from what I read is going on in the credit markets combined with my macro views on the economy - this is about as bearish as I can recall being since 2002. A lot of the "worst case scenarios" seem to be playing out - I am completely flabbergasted the indexes are not down 10-15% lower then they are but as I've written in the past, EVERY asset will be inflated by the easy money policies of printing devalued dollars and flooding them into the world. Including equities. I truly think this is a large component of what is holding up the markets.... but it is very deceiving... if your asset increases by 8% but true inflation is 10-12%, you are underwater in real terms. I do believe this is happening in the equity markets... instead of being down 25-30%, we are down 15%, but in large part to the asset inflation of devalued currency... so we are "saving" ourself from another 10-15% loss but that only feels good on paper - in real terms with heightened inflation all that "saving" we've done has been destroyed by the devaluation of our dollars. i.e. we are 10% higher than we should be in this asset (equity markets), but at the cost of 10% more inflation. So it's a wash. (or worse if you believe inflation is even higher as I do). In simple economic terms we have relatively fixed number of shares available in the US equity markets, but more and more dollars chasing these same shares - therefore inflating them above where they would be in a non "printing press" strategy by the Fed.

But it's a good mirage because people can "measure" assets easily - they open their 401ks, they see the DJIA average daily.... you can't go get a quote for "inflation" in your online brokerage - so you don't feel the true offset to this "buffering" game that is going on. So much like commodities which are higher than they should be due to this buffering of worthless paper dollars, the same is happening in equities in my opinion - only in this case it's making a much larger loss, less so (as opposed to commodities where we are seeing gains)

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